June 6th, 2012; The Pain in Spain is Now Becoming Plain

David: The massive capital flight from Spain over the last two months has been on a scale that I don’t think we have ever seen before in Spain. It is interesting, 50-70 billion dollars per month has been leaving Spain and moving to other jurisdictions.

Kevin: This is a different type of running of the bull.

David: Maybe the running of the bears, though they don’t really have a huge bear population in Spain. But, yes, this is private capital that would rather be somewhere else: German bonds, Swiss paper. In fact, the Swiss National Bank has even suggested capital controls to limit the inflow of money coming from other European countries.

Kevin: David, what strikes me as interesting is that we just finished reading the book, Bonhoeffer, and we looked at Germany as it was starting to go toward more of a war footing. Usually, when you see these types of flight capital moments, they are not economic, they are usually a precursor to war. Isn’t it interesting that we have almost like a financial war, or an economic World War III occurring without the military.

It is interesting, because I think, frankly, the conflicts that we will see over the next 3 to 5 years will be less about tanks and bombs and guns, and more about financial maneuverings. When you look at these on the basis of contract law, when you look at them on the basis of opportunity lost or opportunity gained, it is a very different calculus. But it is still aggressive in nature and we have seen a massive move already toward natural resources in Africa – this is China, primarily – and into hot spots which would otherwise be considered uninteresting or intolerable for anyone with a conscience.

So we will not be acquiring oil in Sudan. We will not be acquiring minerals from certain parts of Africa, because we have a conscience. And yet, there is that issue of “it’s just business” as far as the Chinese are concerned.

Kevin: Speaking of “just business,” going back to Europe, if the new leadership can’t solve this problem, are we looking at some sort of people’s revolt, or do the people even have a say anymore?

David: Right. So, raising the issue in Europe, if technocrats and their bureaucratic brothers don’t emerge with a workable solution to the core versus the periphery incompatibility – the spenders versus the savers, for a very simplistic analogy – the people will revolt via capital markets, and that is exactly what we are seeing now.

Kevin: Flight capital out of the country.

David: That’s a form of revolt. It’s saying, “This isn’t going to work for us. We don’t feel safe here anymore, even if this is our home country. We’re feeling at risk.”

Kevin: Let me ask you a question. If all that money is leaving the country, any country, what happens to the tax revenues? The very thing that these countries actually use to partially pay their debt, it looks like even that is leaving.

David: You are gutting the ability of select countries to generate enough revenue to even maintain the status quo. Once your tax base has moved on, there is nothing for you to do but introduce radical measures. That’s aggressive inflation, hampered by the currency union today, but that may not be an issue for certain countries in the eurozone tomorrow. You have nationalization of assets as an alternative, or complete capital controls. It is important to remember that capital controls were in place in Europe for 30-40 years, leading up to the early 1990s, which was very indicative of the populace’s lack of trust in the system.

Kevin: It was that lack of trust in the system that it took decades for them to build on to finally bring them into this euro. Now it seems like it’s fracturing back out again and going back to that distrust that we remember when we were kids.

David: Right. We’ve discussed capital controls ad nauseam. In retrospect, looking at that 30-40 year period leading up to the EU and the European monetary union, we have always had the movement of capital, and it was very fluid, sometimes on a black market basis, but capital controls were required as a partial solution. Capital controls are the future here, and likely in Europe, as well, and it is worthy of note that prior to conscription of capital comes the closing of the gates, locking as much capital inside as possible.

Kevin: Basically, just making it impossible to move money in or out, if you are a citizen of Spain, or let’s just use the United States as an example, as well, because at some point it will probably happen here, where they just basically put the walls up and say, “Look, we can’t afford for you to take your money out of here.”

David: This was the point of our discussion about the leviathan, the growth of government, several months ago, and the idea that this monster animal will do everything it can to feed itself, to maintain itself, even at the expense of you, whoever you are, whatever jurisdiction you are in. Everyone should think of having a sufficient amount of long-term vacation funding.

Kevin: You love to go to Europe, David, and you love to go to Asia, so what you are thinking is possibly just bringing the money there first (laughter), and taking the vacation later.

David: Or even Canada. There are some beautiful mountains to climb in Canada, some beautiful places to go skiing.

Kevin: Make sure you keep your passports renewed.

David: Kevin, all that we are talking about is aboveboard and legal. You simply don’t want to linger on the issue of when any particular treasury around the world feels that they are losing control, and thus, starts grasping at straws.

Kevin: You were talking, Dave, about how Greece was actually one of the only performing markets last week, so maybe part of the way I get some of that vacation money overseas is that I go buy Greek stock. How is it looking?

David: Well, we’re actually only 1 point above its low for the year.

Kevin: So, does that make it a deal?

David: Not yet, and this is the nature of a bear market, regardless of the geography. It may be Greece, but it could be the U.S. tomorrow, and in fact, we have a Dow theory bear market confirmation just here in the last week.

Kevin: Richard Russell sort of picked up the baton. This is a 100-year-old system that goes back to the beginning stages of the Dow-Jones industrial average itself.

David: Charles Dow was the original creator of those components.

Kevin: And the baton has been carried by an individual writer all the way through the years, all the way through the 1929 crash, after the boom, all the years that we saw the Dow-gold ratio wavering back and forth. At this point, Richard Russell has been writing about the Dow theory for just about, I think, 50 years.

David: More than that, closer to 60, and it is these indicators that have been at the front edge of major declines. We had suggested that a 25% decline may be in the making in the U.S. equity markets, with international equities offering, really, no solace or comfort due to record-high correlations. Everything is moving in one step, one direction, at the same time.

Kevin: David, you have talked about over the next 24-36 months, the next 2-3 years, you are really looking for a substantial decline in the Dow.

David: That assumes central bank intervention becomes less and less effective. That is, in fact, what we are seeing right now.

Kevin: The drag about this is, if you aren’t getting double-digit returns, you are actually not keeping up with inflation right now. So your return that you are actually coming away with, whether it is stocks or bonds, where in the world can a person keep up right now?

David: In all fairness, let’s just say that the official inflation rate is a real-world inflation rate, and all we are dealing with is roughly 2 to 2½ percent inflation. We are talking about single-digit rates of return, low single-digit rates of return, in equities over the next several years, if they are not, in fact, negative. In other words, whatever you are seeing in terms of a positive rate of return is still annihilated, even by a low stated rate of inflation, although we would argue that it is probably higher than that.

Kevin: I would like to talk a little bit about something you just brought up – the correlation in the markets. There seems to be an interconnectedness in the markets where diversity doesn’t really necessarily pan out, because you could be in the Spanish market, you could be somewhere in the euro, and you could also be here buying Facebook. (laughter).

David: And they all represent Flopbook at this point.

Kevin: David, with what we are seeing in the stock market, or just not being able to diversify, really, anywhere right now to get a positive rate of return. Is there any way to at least keep up?

David: I would remind you that the low to negative rates are the perfect environment for precious metals as investors practice their opt out of a very poor risk/reward scenario. And as return expectations move to these lower levels, investors are adjusting to low single digits, and again, that inflation bite is more and more dramatic as a component of the real rate of return. What does a person do in light of that frustration? They simply step aside and say, “I don’t want cash because I can see that the central bank will eat my lunch. I don’t want to be in the markets because I can see that that will eat my lunch.” What do you move to? It’s a temporary port in the storm.

Kevin: The market does throw false cues, because there are times when we have these declining markets where we have these rallies that can really thrill the audience, but I’ll tell you what it does – it gets people actually watching financial TV again.

David: Right, and I think we are on the cusp of a relief rally. 18 out of the last 24 days have been down days on the Dow. We have news pending. The Fed announcement on the 20th. We have the euro leaders conference on the 28th and 29th. These dates, the Fed announcement on the 20th, and the euro leaders conference on the 28th and 29th, have the potential for shaping the markets here in the summer months, either positively or negatively. But between now and then, we may see positive expectations drive the market higher.

Kevin: I want to ask you about that. The unemployment numbers. We have heard with past guests that when you have high unemployment, you don’t have an incumbent president getting back in. We have these employment numbers that came out and they weren’t pleasant. They were really, really rough, to be honest with you.

David: Yes, we were hearing toward that magic 7.4 number. Again, that is the classic dividing line between an encumbent being re-elected or not being re-elected. If the unemployment number is above 7.4, an incumbent has never been re-elected in U.S. history. However, if it is below that, and we certainly were trending, from 10, to 9, to 8, to … and we didn’t quite get there. We are moving back up toward 8.2.

Kevin, the May numbers, you are right, they weren’t pleasant. And in fact, if you look at the revisions lower for the two previous months, it would imply that we have been in a downtrend in terms of employment growth here for several months now, just simply papered over. One of the things that they have used to paper over that reality is the birth/death model, where we had 204,000 jobs added in the most recent numbers. Again, that is just a reminder that this is a statistical add-in.

Kevin: It’s like, how about we add 204,000? Let’s just add some numbers.

David: Right, and in fairness, it seasonally either helps or hurts the total net employment numbers, because you can add in, or you can subtract out, on the basis of this birth/death model.

Kevin: Speaking of papering over, Dave, let me ask you a question about the political pressure on the Federal Reserve. We have seen this in election years, really, all of our lives, where the Federal Reserve tends to act in symmetry with what the incumbent wants. My question to you is this: Are they going to bow to that pressure now, and paper over this unemployment number with a lot of inflation?

David: I think part of the danger in our current economic situation is that U.S. leadership is distracted by a pending election, and the best thing that they are going to do is continue to pick up the phone and pressure the Fed and Treasury to do all they can in the face of these deteriorating jobs figures. Of course, there are other signs of slowing growth, but the problem is that the Fed may or may not play ball, and while we continue to doubt their independence, they are witnessing the “do more interventionism…”

Kevin: Just do something.

David: It’s not actually doing that much! It’s been selectively successful and we should, in reality, be further along down the road to recovery, but we are not. That fact is mildly disconcerting to the Fed. But again, they are not willing to say we have been wrong, or our policies have been wrong. They just really don’t have an explanation. Even though they have created 1.6, 1.7 trillion dollars in excess liquidity, that is not in the economy as it was intended. That is back on their balance sheet, redeposited, excess reserves, from depository institutions, back with the Fed. They are having to scratch their heads and say, “We were willing to create liquidity. We were willing to do everything we could to monetize debt – to print, etc.” But guess what? It’s not having an effect.

Kevin: So, don’t hold your breath for a second version of Maestro II for Ben Bernanke. Alan Greenspan got his book, and I’m wondering what Bernanke’s book is going to read like.

David: Following the June 20th Fed meeting we have the euro leader meeting at the end of the month, and we anticipate problematic handling of the debt ceiling later in the summer. Again, that’s a U.S. issue. Then in the fall, we have the whole issue of the fiscal cliff.

Kevin: Let’s explain the fiscal cliff. What is the fiscal cliff, and why should I be worried about that?

David: Last year an agreement was made that if they couldn’t come to an agreement, there would be an automatic downshift in terms of spending, roughly 4% of GDP. Again, the wranglings around the fiscal cliff, the wranglings around raising the debt ceiling, the wranglings around whether the Fed intervenes or doesn’t intervene – all of these are potential triggers for a downgrade of U.S. credit. We have already seen the Triple A status marred by one rating agency last summer, going from Triple A to Double A+, and we think that this could, again, be the trigger for an increase in interest rates, and frankly, a larger ratchet down in equities.

Kevin: This brings up something from a few weeks ago when we had Richard Duncan on. He had said, “Look guys, you need to understand. This economy, for at least four decades, has been growing mainly by our ability to borrow more money and spend, borrow more money and spend.” It’s the perfect Keynesian approach until it doesn’t work. Would you say the greatest risk of the day right now is that debt expansion is not working?

David: Well, it’s this: Debt has been expanding for 30-40 years, and that game of growth predicated on credit expansion is over. In place of it, guess what government is offering? Credit expansion. (laughter) That’s the problem. Debt expansion among governments has been the solution on offer from our global central bankers in light of a slowing global economy. As a result, we now have developed world countries swimming in debt.

Kevin: David, I have gone out to eat with people who eat gluten-free. They look at the menu and they say, “Do you have anything without gluten in it?” This debt thing is reminding me of the restaurant that serves everything with gluten. It’s like, “Wheat Are Us”. Except in this particular case, it is “Debt Are Us.” It’s the only solution they have in their quiver.

David: This is the problem we see, because liabilities on a massive scale are now common across the financial markets, and thus, the interconnectedness of the global financial markets is on a scale never witnessed before. This is the real point. The correlation amongst your financial assets, correlation amongst every country in the world, is at a level we have never witnessed before.

Last month, U.S. stocks dropped 6-8%, European shares over 7%, Asian markets over 8%. How about that difference between domestic versus international equities? How is it taking care of you in terms of a diversified portfolio, and the salvation, or the lack of risk, that is supposed to bring to the portfolio?

Kevin: David, this is a paradigm that is so hard to break, because our generation, growing up, was always taught, “Diversity, diversity, diversity. The efficient market theory has been proven, if you just move money all around in different directions, at some point you are going to actually be coming out ahead most of the time.” The problem with diversification, in this particular case, is that all of these markets, like you said, are correlated. If it rolls over, they all go down.

David: And it is not that I have anything against diversification. It’s just that when we look at a diversified portfolio we are talking about three mandates, the first mandate being liquidity – cash or cash equivalents. The second mandate is growth, or growth in income. The third mandate is insurance – precious metals. This is a diversified portfolio. What most asset allocators do on Wall Street is pick the growth and income portion of your portfolio and try to diversify within that space alone…

Kevin: Which is all correlated…

David: And leaving you completely under-allocated to cash, and under-allocated to precious metals, and undiversified while pretending that you are diversified because you are an international large cap, or mid-cap value, or small-cap growth. All of those things are supposed to represent diversification, and they don’t.

Again, we come back to the issue of correlation amongst financial assets, as a result of the ubiquity of debt. There is so much debt in the system today, holding the system up. This is where we are, frankly, terrified – terrified that with the declines we have seen thus far of 8-9%, following a snap-back rally here in the next few days to weeks, we could very well see, again, another 2008 repeated this year.

Kevin: Not that you are certain that 2008 will happen again the way that it happened before. I think sometimes we have a tendency to look back and say, “Okay, well, it’s going to be like that, only worse.” But the thing is, this time around, we have so much more inflation built in to the system. You have talked about this wall of money that is sitting out there that has yet to get into the system.

David: And it is latent. You can’t see it. Yet the smartest people I read, every day, every week, every month, are saying, “Listen, on the horizon we’re going to have major inflationary problems.” Guess where that is not priced in, one iota? It’s not priced into the bond market. We’re seeing the U.S. bond market at ridiculously low yields, at ridiculously high prices, which would assume there are no inflationary concerns, whatsoever. The smartest guys in the whole investment world, the bond guys, are getting it dead wrong, as they have completely underestimated the probabilities of inflation over the next 2-3 years.

Kevin: David, this is a sad thing, but I think they’re not the smartest guys anymore. The smartest guys are the ones who say we should have been learning Chinese, that if we’re going to learn a language, we should learn Chinese, because the Chinese, and the Indians, have been buying the greatest majority of gold, which is pricing in, and is continuing to price in, the devaluation of currencies.

I just read something the other day that stated that the Chinese buying over the last four months is up 700%. These guys are seeing it. It’s not the bond guys that are seeing it, it’s the Chinese.

David: In fact, you’re right. The bond guys who are playing the old bond vigilante game are the ones who are going to get burned. The new bond vigilante game is being played in the gold market, the only bet that is successful against a manipulated Treasury market, whether it is our Treasury market, or the bund market in Germany, or anywhere else. That’s where the bond vigilantes will go.

One last point, Kevin, on the 2008 global cascade in equities. We are not certain that such a fall is on the horizon now. We know that confidence is fragile. We know that systemic shocks are latent in the system, and frankly, there are too many to count. Really, to us, it’s just a question of when, not if. And when that occurs, we will see some of the giants of finance erased from the marketplace – counter-party dependency and the infectious nature of risk-pooling.

Again, we are just under-prepared, under-reserved, not enough liquidity. Again, what we were just describing in terms of a Wall Street asset allocation model where everything is fixated on growth and income and you don’t have enough in liquidity, and you certainly don’t have enough in insurance. This is not just what Wall Street recommends to their clients, it is what they have done with their own balance sheets, and we think that the surprise will be, even in the biggest bear community – the folks who are assuming a decline – that this is going to hit them faster, and more severely, than even they expect.

Kevin: We have thought that bonds are where you go when you really don’t want to take the risk in the equities market. Do you think, at this point, the reason rates are so low and everyone still runs to bonds, or runs to the dollar every single time something happens, do you think it’s muscle memory? Do you think it’s just not really understanding that they are like Wiley Coyote, just running right off the cliff?

David: It’s something that you and I have discussed many times, the idea of normalcy bias, that you just assume that what has been the case for 10, 20, 30 years, will always be the case over the next 10, 20, 30 years, and you lack the imagination to imagine anything other than the status quo. The pending 2012 events – the fiscal cliff, the debt ceiling wrangling, either or both – that are likely to raise the issue of U.S. fiscal sufficiency; credit quality then becomes an issue, and begins to recalibrate for anyone suffering from normalcy bias. Again, the question is asked, “Are we actually a reliable debtor?”

Kevin: David, we all know that this country is not a reliable debtor. We don’t know how long it’s going to take, but unfortunately, while we are waiting, the middle class in this country is being gutted. We have the elite, and we have the poor. The middle class is paying for this, and actually, they are sort of the suckers on this. A friend of ours, Marc Faber, who has been on this program numerous times, is now saying that income disparity is becoming standard issue.

David: Right. It’s not because of unfair taxation, and it’s not because of anything really like a great advantage to someone who is succeeding in the corporate or capitalist world, but rather, it is through Federal Reserve activity.

Kevin: David, talking about muscle memory, we really don’t know how long we are going to have good credit in the eyes of those who are still deceived. As long as they believe we can repay, and as long as they continue to go buy bonds, and every time something happens and they get scared and they run back into bonds, then sure enough, you can maintain those unusually low interest rates and gut the middle class.

That’s what is happening right now. The middle class doesn’t understand that it is being played for a sucker. The Fed is printing money and artificially keeping interest rates low, and we will pay, either in the form of inflation, or in the form of negative real rate of return. This is not a new problem. Marc Faber has been talking about it for a long time.

David: I think our creditors are also aware that they are being played for suckers. The repression of interest rates, and pressing rates well below their natural level, is one way of getting around paying your creditors their due. So we already see that, and it is apparent to everyone that the circumstances are desperate enough that we need to repress interest rates in order to keep this game going.

The next step, after repression doesn’t work, or if it quits working, is inflation, and is the route which is most painful for the middle class, because in this circumstance you may not have the ability to increase your income. There is always a benign effect with inflation. You can have massive inflation as long as you have massive wage inflation at the same time. Your wages are keeping up with the cost of goods as they are going up in value, too, and that’s okay, because there is an offset.

What is terrible is what we have today is a globalized environment where we may have domestic inflation, but if I need to change my wage or labor relationships, I’ll just take those jobs and take them to another part of the world that is cheaper, which means you will not have the ability to increase your wages, even as we have inflation here in the United States. This is an inflationary depression, where people are, essentially, locked in.

Kevin: This is not a new problem. Marc Faber even goes back and quotes a guy from 250 years ago, David Hume, who said, “How to insert money into the economy, distribute it evenly, and keep the inserted money from being confined to the coffers of a few persons, who immediately seek to employ it to an advantage.”

We have an elite class right now that really doesn’t care if we have inflation, they just want to make darn sure that those five banks that hold over 90% of all the derivative debt out there don’t fail.

David: The problem is not regarded as a problem by the few that benefit. It is the many that suffer, who lose purchasing power, and are, essentially, unable to make an adjustment, who feel the pain. To be clear, the advantage of the 1% is conferred, it’s not taken, and by that, I mean that it is conferred by the Federal Reserve System.

Kevin: We can thank Keynes for that. It’s the ideology of Keynes that probably is the one that is the most at fault for the decline and fall of Western civilization, when it comes.

David: There’s an irony here, because, while he was sort of the high priest of central bankers, we find that he was both a money and power elitist, while he advertised himself as more of a populist, had a broadly populist sales pitch, for government handouts and large spending programs. Ultimately, I take this as an insult to the intelligence of the lower and middle class, that they are basically played as a small part in the system, a cog in the wheel, if you will, in which the power- and the money-elite gain efficiency and take power, benefiting from them just playing their role. So certainly, give them their bread and circuses, and we will continue to rule. It is fascinating, when you look at his life, he was the anti-capitalist who was absolutely enthralled with, and made his fortune in, the capital markets.

Kevin: Twice. He made his fortune once, lost it, and then made his fortune again, the whole time talking about how you really don’t want that kind of capitalist greed going on.

David: Right, speculating in commodities on the one hand, but hating speculators publicly because it didn’t fit his role as a social engineer.

Kevin: David, there is one thing that is absolutely critical with Keynes. We talked about being able to borrow, being able to spend, but you have to be able to keep that money moving. That’s the spending part. You have to have velocity of money. This is a problem with Keynes.

David: Velocity is, today, dead.

Kevin: If you print money and you can’t get it to go anywhere, what happens?

David: That’s our issue today. That’s why, frankly, the Federal Reserve is a bit hamstrung. What do they do? What do they do today? It’s not enough to announce QE-III, because look at what happened with QE-I, Q-II, and Operation Twist – temporary reprieve in the stock markets. Now we are coming up on the expiration of Operation Twist here at the end of the month, and guess what we are expecting?

Kevin: Another one.

David: More intervention.

Kevin: Sure.

David: But what benefit was it, other than a temporary reprieve in the decline of equities? Of what benefit was it? We created a tremendous amount of liquidity, in which, as I mentioned earlier, the banking system has taken that liquidity, and instead of lending it out, and that being a growth component in the larger economy, they have taken it and redeposited it with the Federal Reserve. That really wasn’t the Fed’s idea of increasing velocity or increasing the gearing, if you will, in the overall economy.

Kevin: David, if you can’t get it working, one of the things you can do is just give a government handout. We have almost half of the people here in the United States, in one way or another, on some sort of government program.

David: That is the reality. If you want to increase food stamps or food sustenance programs, or just some other form of government benefit, 49% today in the U.S. are on some sort of government benefit program. That is up from 29% in 1983. Food assistance programs continue to see an increased rate of participation. We are in essence codifying the world of the well off, and the not so well off, and those government dependents are the most reliable votes available. The more you increase your dependencies, the more you hand out government cheese, if you will, at this point, the more you are solidifying your voter base.

Kevin: So, instead of printing money, just print it up in the form of food stamps, print it up in the form of government programs, just make sure that you are getting it out that way. The problem is this, Dave. We have all heard of GAAP accounting – generally accepted accounting principles. It’s funny that they would use the term GAAP, because it seems like there is a different gap that has been forming in accounting, as far as our deficits go.

David: Again, this comes back to the two issues that we face later in the year. We have the fiscal cliff, which does relate to households that are affected, with government benefits perhaps being cut. We have the Medicare portion, in which there are doctors who are going to have a change in compensation. This fiscal cliff has many ramifications in both the medical community and the retired community, many swaths of people who will protest when the sting of “austerity” is felt.

Kevin: That comes after the election, I should say. This is one of those things that is not going to affect the outcome of the election.

David: You mentioned GAAP as the acronym for generally accepted accounting principles, and there is a gap in the accounting, not an acronym, but actually something missing in the government’s method. It is, essentially, ignoring the 800-pound gorilla in the room. It is called future liabilities. That is how we turn an annual deficit, here in the United States, of 5 trillion…

Kevin: Wait. 5 trillion? It’s 1½ isn’t it?

David: 1.3.

Kevin: Oh, it’s 1.3, right.

David: That’s what they’ve come up with. But the government gets to use a different accounting method than a publicly traded company does. A publicly traded company has to account for their future liabilities and that gets factored in. We, the people, don’t have to do that. The government doesn’t have to do that. We turn out a 5 trillion dollar deficit and, basically, pretty up the pig, call it 1.3 trillion, call that good, and now we wrangle over the debt ceiling.

Kevin: So, David, the numbers are manageable as long as the numbers, themselves, are managed.

David: As long as they are being managed, exactly! Massaged. Kevin, just boiling this down to one practical piece of advice, this was explored in brief in the Bloomberg interview that I did last week with Trish Regan. The commentator, who was from RGO Bryan, said, “You’ve got to be careful of U.S. Treasuries, and you probably should own gold, because from current prices, we would expect over the next two years to see it trade at close to $5000 an ounce.

Kevin: That wasn’t you.

David: It was not me. It was not me.

Kevin: (laughter) A surprise!

David: All that you could hear in the background was my echo, “$5000 an ounce.” But really, when you look at the liability structure, not just in the U.S., but globally, what the world’s central bankers have done to keep this project moving forward and keep us on a “growth footing” has compromised our future significantly.

Kevin: David, let’s just look at who is being played for a sucker. We talked about this before, but we have these people who are accumulating gold. Central banks right now are net accumulators of gold. The Chinese are net accumulators of gold – gosh, that’s an understatement almost. But what we have with the American public, you brought this up before, the buying of gold here in America, if people think that people are buying gold in America, they are fooling themselves. We aren’t buying more than about twice what Turkey is buying, and about 2½ times what Vietnam is buying. The Chinese are buying it all, the central banks are buying it all, yet we are being told by those same bankers, “Hey, go buy bonds. Go buy Facebook.”

David: Little Lucy Lemming is looking at this and saying, “I’m very scared right now, I think I’d like a pool of liquidity.” Little Lucy Lemming loves liquidity, and that is in the form of 10-year Treasury bonds. That is in the form of 2-year Treasury notes. That is in the form of Treasury bills. Bills, bonds, and notes are what are most popular today – exactly at the wrong time. As we mentioned in the Bloomberg interview last week, there is more risk inherent in the bond market today, or maybe last Friday, actually…

Kevin: (laughter) That was bad.

David: … than at any time in 30 years. So to see mean reversion in interest rates, to see mean reversion occur in the stock market, as risk is reappraised, all of a sudden bonds are not as safe as you thought they were, and thus, equities have to be revalued in a new environment of risk. We see great, great pains ahead over the next 2-3 years. Is that between now and the end of the year? Possibly. Probably? Perhaps.

There really is no way, without a crystal ball, to know both the timing and the event, but we can see the events unfolding, although we do remain uncertain about the timing. Is it this year? Is it 2013? Is it 2014? The bond market, and a blow-up in the U.S. equity markets as a result, are, in our opinion, a certainty, just on the horizon.

Kevin: David, talking about pain. You don’t have to endure pain. If you see pain coming in a particular area, just stop touching the stove. It is something that every little kid has to learn the hard way, once. There are some people who have to learn it maybe a second, or a third, or a fourth time, but you don’t have to be in the bond market. You have to have something, though, that is outside of that. This is one of the things that is coming up more and more, and that is, you talked earlier about the opt-out strategy. When you are talking about opting out, you can’t be waiting for somebody else’s liability to pay off. Of course, that brings us back to gold. I know that is obvious.

David: The issue, I think, can be resolved handily. If you want to read the recent Smart Money magazine, the smartest guys at Smart Money are saying you don’t need to own gold, and I would encourage all of our listeners to get a copy of Smart Money and read about why the common man is not going to own gold, because he has been told by the smartest people in the room that it is not necessary, and here are all the reasons why.

Kevin: David, I read that article. It is insulting to the intelligence of anybody who reads it. It is almost as if they are speaking to children and telling them something that is absolutely untrue, but they want them to do it anyway.

David: In truth, yes, it is a poor excuse for financial journalism, but it is worth all of our listeners reading it, to realize what the consensus view of owning gold is. The common man is not in the market. The hedge fund community, on the other hand, is used to flying high and moving fast. They are used to taking risks, and they understand the value of a roll bar. They are, at this point, very concerned with systemic stability, and there is a growing number of sophisticated hedge fund managers who want their stake in gold.

Meanwhile, the “smart money investor,” the man on the street, the hoi polloi, is setting himself up for disaster as he moves into fixed income and out of bonds. If you look at the mutual fund flows out of equities and into bonds over the last three years, three years in a row, the average man on the street has said, “I’m tired of equities, I just want bonds. A fixed income will do.”

Kevin, this is exactly what we are talking about. That is being supported by the folks at Smart Money and the move away from gold, again, is being buttressed by the folks at Smart Money. Isn’t this ironic?

Kevin: So the bottom line, David, is that when you are coming out of paper equity, and going into paper bonds, there is at time when someone is going to say, “Wait a second. The King has no clothes on. Let’s get out of bonds.” And where do they go? They have to go to gold.

David: At the end of a 30-year credit cycle, the last place that you would want to go is the bond market. Even if it is rewarding for you on a short-term basis, it is a market to be traded, not invested in.